INVESTMENT MANAGEMENT
THE INVESTMENT CASE FOR A EUROPEAN CORE OFFICE FUND
1.0. INTRODUCTION
In this short paper we set out the case for investing
in a European core office fund1. The report
is specifically focused on the benefits of such
investment for BNP Paribas REIM clients.
1.1. Executive Summary
Our research strongly supports investment in a
portfolio of diversified core offices. There are two
main arguments supporting our view:
The highly attractive investment characteristics
of this asset class, including its size and liquidity,
long-term risk-adjusted returns, diversification,
strong income orientation and inflation hedge
characteristics.
A number of economic and investment trends
that particularly support such a portfolio in
today’s investment climate. These trends include
(i) elevated “tail” risks of continued low-growth
unfolding in which core property would perform
favourably, (ii) reasonably attractive pricing, (iii)
supply at record lows and (iv) the ability to benefit
from the next rental cycle.
In order to deliver superior risk-adjusted returns
and preservation of capital for investors, our
research recommends assets that exhibit the
following property attributes:
High-quality, stabilised income streams based on
superior tenant quality and credit.
Attractive buildings with high-quality physical
characteristics.
Excellent location factors.
Leading sustainability features (preferably
certified).
Markets that will reward core investors by offering
a mix of desirable features such as higher riskadjusted returns, solid rent growth, great supply
constraints, and high levels of market liquidity. Our
preferred markets include cities such as2:
• Berlin
• Brussels • Dublin
• Frankfurt • Hamburg • Madrid
• Milan
• Munich
• Paris
2.0. THE BENEFITS OF A DIVERSIFIED CORE OFFICE
PORTFOLIO
2.1. Largest and most liquid sector
The size of the office sector is larger compared
to the other sectors, the characteristics of offices
investment are more easily ‘understood’ and,
finally, offices are easier to trade. Moreover, this is
the most traded and liquid real estate sector3.
Our definition of core is in line with INREV style classification parameters.
This list is not exclusive. Cities are ranked according to an alphabetical order.
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Source: IPD and RC Analytics.
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2.2. Attractive risk-adjusted returns
A real estate portfolio acts as an essential
component of an investment portfolio, providing
current income and the potential for capital
appreciation. Historical office total returns are
robust and risk-adjusted returns are far more
attractive than bonds or stock4 .
2.3. Diversiflcation
In a multi-asset portfolio, office real estate offers
low or negative correlation with the performance
of other major asset classes. Moreover, it provides
diversification across the various geographies and
economic bases in which the assets are located.
Multi-tenanted buildings add a further dimension
of diversification.
2.4. Income
Ultimately, real estate is primarily an incomeoriented investment, supplemented with the
opportunity for capital appreciation. Historically,
in Europe more than 70% of total office returns
have been generated by income between 2000
and 20125. The income generated by real estate
is attractive relative to most other investment
asset classes. Income from institutionally-owned
commercial real estate is also more stable than
dividends from REITs.
2.5. Partial infiation hedge
Real estate generally benefits from increasing
rents and rising property values when inflation
rises. This is a key element in contrast to bond
and stock investments. Furthermore, core real
estate as a hedge against inflation has been
shown to be particularly effective in tight, supplyconstrained markets. As such, it is essential to
focus on those markets that exhibit low vacancy
and strong supply-constraints as the spectre of
rising inflation increases.
As we are currently more pressed by concerns
about very low rates of inflation and the chance
of deflation it may not seems really proper to
talk about inflation risks. However, we should
note that this analysis is not concerned with the
short-term but is aimed at the long-term. The risk
of deflation for real estate is mainly via cost of
capital channels, with higher real interest rates
and increased risk premium increasing discount
rates. In this sense, core portfolios are less
prone to be affected by shocks, not least because
deflation is particularly problematic in conditions
of high leverage. Overall, the ECB has several
tools at its disposal to ward off deflation including
strengthening forward guidance on rates,
setting negative interest rates and introducing a
quantitative easing program. Given the indebted
nature of western economies, we expect all
measures will be taken to avoid deflation.
3.0. CURRENT TRENDS SUPPORTING INVESTMENT
IN A DIVERSIFIED CORE OFFICE PORTFOLIO
3.1. ¨Tail risks¨ are high: Core property may
perform particularly well in these outcomes
The risk of ongoing sluggish growth is high. In
this event, a diversified core real estate portfolio
provides the investment characteristics to
perform favourably. In this scenario, a sluggish,
low growth economic environment provides little
support for asset appreciation. In turn, income is
more valuable. As a result, an income-oriented
portfolio of diversified real estate is particularly
appealing to investors. While private deleveraging
has helped to perpetuate a sluggish recovery thus
far, history indicates that periods of low-growth
in the wake of bursting credit bubbles may persist
for longer than anticipated. Core funds have
A very simple measure of the risk-adjusted return of an asset (namely the average historical return divided by the standard deviation of
returns over a period of time) for European office real estate is 1.8, vs. 1.3 and 0.2 for stock and governmental bonds, respectively, over the
2000 - 2012 period. The analysis can be provided at request by BNP Paribas RE International Research.
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Source: BNP Paribas International Research based on IPD data.
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performed much better than value-added ones
over the last 10 years. While valued-added funds
have performed better before the crisis, they were
affected much more than core funds during the
downturn and henceforth6.
3.2. Historic volatility experienced in other
asset classes
A pressing concern for investors is the heightened
volatility experienced in many other asset classes
(stocks, bonds, commodities) over the past several
years. In this environment, income-oriented,
commercial real estate, and especially, core office
stock, provides considerable relative stability.
3.3. Pricing remains attractive compared to
historical norm
An analysis of office yields spreads to the 10year bund yield reveals that these indicators are
near historic highs. As a result, investors appear
to be assigning a comfortable risk premium to
office real estate. Nonetheless, a significant factor
contributing to these wide spreads is an artificially
low-yielding bond market due to low rates and
quantitative easing measures in the US. This indeed
represents a risk that investors are not accurately
pricing risk. While the risk is more substantial for
prime real estate in specific markets (e.g. London
West End), it is less of a concern for good-quality
core product where yields are higher.
3.4. New supply of commercial real estate is
at record lows
Among all major property types, the supply of new
product remains stalled at levels not experienced
in decades. The current dearth of construction
bodes extremely well for investors. Forecasts for
stock growth for the office sector look considerably
more anaemic over the next five years.
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3.5. A rental up-cycle is expected
The European economy is improving and
employment growth will follow suit. A business
up-cycle is expected with total returns and rent
growth to perform solidly over the medium
term. Rental growth is anticipated to be solid in
Germany. Rental values in Paris are expected to
stabilise this year and to return to growth from
2015. Rental values in the South (Milan and
Madrid) should bounce back dramatically when
the economic recovery is established.
4.0. STRATEGIES TO DELIVER SUPERIOR RISKADJUSTED RETURNS
4.1. Property-speciflc recommendations
The fund will focus on the following real estate
attributes among acquisition candidates:
High-quality, stabilised income streams based
on superior tenant quality and credit.
Attractive buildings with high-quality physical
characteristics.
Excellent location factors in supply-constrained
markets that (i) provide competitive market
positions (ii) reduce exposure to new development
and (iii) are easily accessible to important transit
nodes.
Leading sustainability features, or the opportunity
for these features to be modestly integrated into an
asset. This not only increases the ability to attract
credit tenants and reduces operating expenses,
but also addresses the risk of obsolescence. It
also caters to some investors’ desire for socially
conscious investments.
While CBD properties are generally the most
secure, selected out-of-CBD assets will also provide
significant value. Out-of-CBD office presents a
Source: INREV industry data.
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compelling argument particularly based upon
current valuations and the prospects for higher
employment growth. Wide gaps in pricing exist
between CBD and out-of-CBD properties exist as
well. Certain strategically located properties located along regionally important transit nodes
or in emerging, trendy areas – are worthy of extra
attention.
Our preferred office markets are economies
containing large, high-growth, office-using
industries such as professional/business services,
high-tech and healthcare. These markets are also
characterised by high levels of liquidity. Examples
include:
• Berlin
• Frankfurt
• Milan
• Brussels
• Hamburg
• Munich
• Dublin
• Madrid
• Paris
Our strategy will first look at German cities where
economic prospects are stronger and rental
growth is going to be stable. Paris will also return
to rental growth from next year while it also has
the advantage of being one of the most liquid and
transparent markets in the world. As a result,
Germany and France, the most solid European
markets, will form the bone of the portfolio
allocation. Tactical allocations will also take
advantage of opportunities in cyclical markets. For
example, rental values in the South (Madrid and
Milan) are expected to bounce back strongly from
next year, while some yield compression is also
anticipated7.
The case for sustainable building is based on cost
reduction for tenants and reputational advantage
to the investor. Evidence from the US market
points a higher rental values reached for certified
buildings. As a result of building characteristics,
such as energy efficiency and technical quality, it
is assumed that there are effects on returns due to
lower operating costs, a lower risk of tenant loss
and increased rental income and preservation of
value. It is true that, nowadays, most investors
believe that, from a risk-return viewpoint, it makes
sense to concentrate on sustainable buildings. As
a result, our guidelines are:
Assume that the “sustainability rating” of a
building will impact on value either positively or
negatively.
Don’t buy buildings unfit for the necessary
requirements of sustainability or sustainable
buildings in secondary locations.
Do buy older buildings that we can adapt to
current best practice or at least improve enough to
improve its value via asset management, property
management or building works.
This document was produced on behalf of
BNP Paribas Real Estate Investment Management
Business Line.
4.2. Sustainability
The search for a relation between the sustainability
characteristics of a building and its rental or/and
capital value began a few years ago. While a lot
of survey work is available, empirical evidence is
still fragmentary and inconclusive. Most of the
literature comes from Anglo-Saxons countries8.
Maurizio Grilli
Head of Investment Management Analysis and Strategy
Tel. : +33 (0)1 47 59 21 37
[email protected]
A detailed analysis of the prospects for the investor is to be found in “European Office Market Insight Winter 2013-2014” by BNP Paribas
International Research.
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A good survey of both literature and empirical evidence on real estate sustainability is: “Is sustainability reflected in commercial property
prices: an analysis of the evidence base” by RICS 2010.
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